Doctored Photo Credit: Marvin Isidore Macatol || And I say this is heresy!

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My last post produced the following question:

What if your time horizon was 60 years? Would a 5% real return be achievable?

I am answering this as part of an irregular “think deeper” series on the problems of modeling investment over the very long term… the last entry was roughly six years ago.  It’s a good series of five articles, and this is number six.

On to the question.  The model forecasts over a ten-year period, and after that returns return to the long run average — about 9.5%/year nominal.  The naive answer would then be something like this: the model says over a 60-year period you should earn about 8.85%/year, considering that the first ten years, you should earn around 5.63%/year.  (Nominally, your initial investment will grow to be 161x+ as large.)   If you think this, you can earn a 5% real return if inflation over the 60 years averages 3.85%/year or less.  (Multiplying your capital in real terms by 18x+.)

Simple, right?

Now for the problems with this.  Let’s start with the limits of math.  No, I’m not going to teach you precalculus, though I have done that for a number of my kids.  What I am saying is that math reveals, but it also conceals.  In this case the math assumes that there is only one variable that affects returns for ten years — the proportion of investor asset held in stocks.  The result basically says that over a ten-year period, mean reversion will happen.  The proportion of investor asset held in stocks will return to an average level, and returns similar to the historical average will come thereafter.

Implicitly, this assumes that the return series underlying the regression is the perfectly normal return series, and the future will be just like it, only more so.  Let me tell you about some special things involved in the history of the last 71 years:

  • We have not lost a war on our home soil.
  • We have not had socialism to the destructive levels experienced by China under Mao, the USSR. North Korea, Cuba, etc.  (Ordinary socialism isn’t so damaging, though there are ethical reasons for not going that way.  People deserve freedom, not guarantees.  Note that stock returns in moderate socialist countries have been roughly as high as those in the US.  See the book Triumph of the Optimists.)
  • We have continued to have enough children, and they have become moderately productive workers.  Also, we have welcomed a lot of hard working and creative people to the US.
  • Technology has continued to improve, and along with it, labor productivity.
  • Adequate energy to multiply force and distribute knowledge is inexpensively available.
  • We have not experienced hyperinflation.

There are probably a few things that I have missed.  This is what I mean when I say the math conceals.  Every mathematical calculation abstracts quantity away from every other attribute, and considers it to be the only one worth analyzing.  Qualitative analysis is tougher and more necessary than quantitative analysis — we need it to give meaning to mathematical analyses.  (What are the limits?  What is it good for?  How can I use it?  How can I use it ethically?)

If you’ve read me long enough, you know that I view economies and financial markets as ecosystems.  Ecosystems are stable within limits.  Ecosystems also can only develop so quickly; there may be no limits to growth, but there are limits to the speed of growth in mature economies and financial systems.

Thus the question: will these excellent conditions continue?  My belief is that mankind never truly changes, and that history teaches us that all governments and most cultures eventually die.  When they do, most or all economic arrangements tend to break, especially complex ones like financial markets.

But here are three more limits, and they are more local:

  • Can you really hold for 60 years, reinvesting and never taking a material amount out?
  • Will the number investing in the equity markets remain small?
  • Will stock be offered and retired at ordinary prices?

 

Most people can’t lock money away for that long without touching it to some degree.  Some of the assets may get liquidated because of panic, personal emergency needs, etc.  Besides, why be a miser?  Warren Buffett, one of the greatest compounders of all time, might have ended up happier if he had spent less time compounding, and more time on his family.  It would have been better to take a small part of it, and use it to make others happy then, and not wait to be the one of the most famous philanthropists of the 21st century before touching it.

Second, returns may be smaller in the future because more pursue them.  One reason the rewards for being a capitalist are large on average is that there are relatively few of them.  Also, I have sometimes wondered if stock returns will fall when the whole world is employed, and there is no more cheap labor to be had.  Should that bold scenario ever come to pass, labor would have more bargaining power in aggregate, and profits would likely fall.

Finally, you have to recognize that the equity return statistics are somewhat overstated.  I’m not sure how much, but I think it is enough to reduce returns by 1%+.  Equity tends to be offered for initial purchase expensively, and tends to get retired inexpensively.  Businessmen are rational and tend to go public when stock valuations are high, pay employees in stock when valuations are high, and do stock deals when valuations are high.  They tend to go private when stock valuations are low, pay employees cash in ordinary times, and do cash deals when valuations are low.

As a result, though someone that buys and holds the stock index does best, less money is in the index when stocks are low, and a lot more when stocks are high.

Inflation Over 60 Years?

I mentioned the risk of hyperinflation above, but who can tell what inflation will do over 60 years?  If the market survives, I feel confident that stocks would outperform inflation — but how much is the open question.  We haven’t paid the price for loose monetary policy yet.  A 1% rise in inflation tends to cut stock returns by 2% for a year in real terms, but then businesses adjust and pass through higher prices.  Vice-versa when inflation falls.

Right now the 30-year forecast for inflation is around 2.1%/year, but that has bounced around considerably even within a calm environment.  My estimate of inflation over a 60-year period would be the weakest element of this analysis; you can’t tell what the politicians and central bankers will do, and they aren’t sure themselves.

Summary

Yes, you could earn 5% real returns on your money over a 60-year period… potentially.  It would take hard work, discipline, cleverness, frugality, and a cast iron stomach for risk.  You would need to be one of the few doing it.  It would also require the continued prosperity of the US and global economies.  We don’t prosper in a vacuum.

Thus in closing I will tell you that yes, you could do it, but there is a large probability of failure.  Don’t count on buying that grand villa on the Adriatic Sea in your eighties, should you have the strength to enjoy it.

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I recently received two sets of questions from readers. Here we go:

David,

I am a one-time financial professional now running a modest “home office” operation in the GHI area.  I have been reading your blog posts for a couple years now, and genuinely appreciate your efforts to bring accessible, thoughtful, and modestly stated insights to a space too often lacking all three characteristics.  If I didn’t enjoy your financial posts so much, I’d request that you bring your approach to the political arena – but that’s a different discussion altogether…

I am writing today with two questions about your work on the elegant market valuation approach you’ve credited to @Jesse_Livermore.   I apologize in advance for any naivety evidenced by my lack of statistical background…

  1. I noticed that you constructed a “homemade” total return index – perhaps to get you data back to the 1950s.  Do you see any issue using SPXTR index (I see data back to 1986)?  The 10yr return r-squared appears to be above .91 vs. investor allocation variable since that date.
  2. The most current Fed/FRED data is from Q32016.  It appears that the Q42016 data will be released early March (including perhaps “re-available” data sets for each of required components http://research.stlouisfed.org/fred2/graph/?g=qis ).  While I appreciate that the metric is not necessarily intended as a short-term market timing device, I am curious whether you have any interim device(s) you use to estimate data – especially as the latest data approaches 6 months in age & the market has moved significantly?

I appreciate your thoughts & especially your continued posts…

JJJ

These questions are about the Estimating Future Stock Returns posts.  On question 1, I am pulling the data from Shiller’s data.  I don’t have a better data feed, but that should be the S&P 500 data, or pretty near it.  It goes all the way back to the start of the Z.1 series, and I would rather keep things consistent, then try to fuse two similar series.

As for question 2, Making adjustments for time elapsed from the end of the quarter is important, because the estimate is stale by 70-165 days or so.  I treat it like a 10-year zero coupon bond and look at the return since the end of the quarter.  I could be more exact than this, adjusting for the exact period and dividends, but the surprise from the unknown change in investor behavior which is larger than any of the adjustment simplifications.  I take the return since the end of the last reported quarter and divide by ten, and subtract it from my ten year return estimate.  Simple, understandable, and usable, particularly when the adjustment only has to wait for 3 more months to be refreshed.

PS — don’t suggest that I write on politics.  I annoy too many people with my comments on that already. 😉

Now for the next question:

I have a quick question. If an investor told you they wanted a 3% real return (i.e., return after inflation) on their investments, do you consider that conservative? Average? Aggressive? I was looking at some data and it seems on the conservative side.

EEE

Perhaps this should go in the “dirty secrets” bin.  Many analyses get done using real return statistics.  I think those are bogus, because inflation and investment returns are weakly related when it comes to risk assets like stocks and any other investment with business risk, even in the long run.  Cash and high-quality bonds are different.  So are precious metals and commodities as a whole.  Individual commodities that are not precious metals have returns that are weakly related to inflation.  Their returns depend more on their individual pricing cycle than on inflation.

I’m happier projecting inflation and real bond returns, and after that, projecting the nominal returns using my models.  I typically do scenarios rather than simulation models because the simulations are too opaque, and I am skeptical that the historical relationships of the past are all that useful without careful handling.

Let’s answer this question to a first approximation, though.  Start with the 10-year breakeven inflation rate which is around 2.0%.  Add to that a 10-year average life modification of the Barclays’ Aggregate, which I estimate would yield about 3.0%.  Then go the the stock model, which at 9/30/16 projected 6.37%/yr returns.  The market is up 7.4% since then in price terms.  Divide by ten and subtract, and we now project 5.6%/year returns.

So, stocks forecast 3.6% “real” returns, and bonds 1.0%/year returns over the next 10 years.  To earn a 3% real return, you would have to invest 77% in stocks and 23% in 10-year high-quality bonds.  That’s aggressive, but potentially achievable.  The 3% real return is a point estimate — there is a lot of noise around it.  Inflation can change sharply upward, or there could be a market panic near the end of the 10-year period.  You might also need the money in the midst of a drawdown.  There are many ways that a base scenario could go wrong.

You might say that using stocks and bonds only is too simple.  I do that because I don’t trust return most risk and return estimates for more complex models, especially the correlation matrices.  I know of three organizations that I think have good models — T. Rowe Price, Research Affiliates, and GMO.  They look at asset returns like I do — asking what the non-speculative returns would be off of the underlying assets and starting there.  I.e. if you bought and held them w/reinvestment of their cash flows, how much would the return be after ten years?

Earning 3% real returns is possible, and not that absurd, but it is a little on the high side unless you like holding 77% in stocks and 23% in 10-year high-quality bonds, and can bear with the volatility.

That’s all for now.

Composition of Liabilities 1994-2016

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The last time I wrote about this was four years ago.  I have covered this topic off and on for the last 25 years.  As usual, the report got released during a relatively dead time, January 12th, where most people were listening to the preparations for the inauguration.  I’ll give them some credit though — not as much of a dead time as usual; it was in the middle of a work week, AND earlier than usual.  (It would be nice to know when it’s coming, though.)

I have two main messages to go with my two graphs.  The first message is one I have been saying before — beware some of the estimates that you hear, should you hear them at all.  No one wants to talk about this, but what few that do will look at a few headline numbers and leave it there.  Really you have to look at it for years, and look at the footnotes and other explanatory sections in the back when things seemingly change for no good reason.  Also, you have to add all the bits up.  No one will do that for you.  Even with that, you are relying on the assumptions that the government uses, and they are not biased toward making the estimates sound larger.  They tend to make them smaller.

Thus you will see two things that adjust the headline figures.  In 2004, when Medicare part D was created, the Financial Report of the US Government began mentioning the Infinite Horizon Increment.  Now, that liability always existed, but the actuaries began calculating how solvent is the system as a whole if it were permanent, as opposed to lasting 75 years.

The second is the Alternative Medicare Scenario.  When the PPACA (Obamacare) was created in 2010, there was considerable chicanery in the cost estimates.  The biggest part was that they assumed Medicare Part A (HI) would cost a lot less because they would reduce the amount that they would reimburse.  They legislated away costs by assuming them away, and then each year Congress would restore the funding so that there wouldn’t be a firestorm when doctors stopped taking Medicare.  But they left it in for budget and forecast purposes, and showed what the projections would be like if these cuts never took place in what they called the Alternative Medicare Scenario.

So, did the cuts to Medicare part A take place? No.

As you can see they have gone up almost every year since 2010. The liability should not have gone down. If you think the Alternative Medicare Scenario is conservative enough, the liability has remained relatively constant since 2010, not diminished dramatically.

How is the load relative to GDP?  It keeps growing, but since 2010 at a less frantic clip.  The adjusted ratio below includes the Alternative Medicare Scenario.

Final Notes

Remember that we have had a recovery since 2009.  The statistics never assume that we will have another recession, much less a full fledged crisis like 2008-9.  Without adjustment, the Medicare part A trust fund will run out in 2028.  There is no provision for what the reimbursements will be made if the trust fund runs dry.  Social Security’s trust fund will run out a few years after that, and instead of getting 12 checks a year, people will only get 9 of that same amount.  If there is a significant recession, those statistics will move forward by an unknown number of years.  Without congressional action, because there will be a recession, I would expect that both will run out somewhere in the middle of the 2020s, and then the real political fun will begin.

The tendency has been over time to turn these from entitlements to old age welfare schemes.  FDR always wanted them to be self funded entitlements with everybody getting roughly the same treatment by formula, because he wanted the program to have widespread legitimacy across all classes, and no sense of stigma for being a poor old person on the dole.

Given the strategies that exist around qualifying for Medicaid, those days are gone, so I would expect that benefits will be limited for those better off, inflation adjustments eliminated, taxes raised to some degree, eligibility ages quickly raised a few more years, with elimination of strategies that allow people to get more out of the system by being clever.  (As an example, expect the favorable late retirement factors to get reduced, and the early retirement factors to go down even more.)

Does this sound fun?  Of course not, but remember that cultures are larger than economies, which are larger than governments.  The cultural need for supporting poor elderly people will lead funding to continue, unless it makes the government, and the culture as a whole fail in the process, and that would never happen, right?

Photo Credit: Brent Moore || Watch the piggies run after scarce yield!

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If you do remember the first time I wrote about yield being poison, you are unusual, because it was the first real post at Aleph Blog.  A very small post — kinda cute, I think when I look at it from almost ten years ago… and prescient for its time, because a lot of risky bonds were about to lose value (in 19 months), aside from the highest quality bonds.

I decided to write this article this night because I decided to run my bond momentum model — low and behold, it yelled at me that everyone is grabbing for yield through credit risk, predominantly corporate and emerging markets, with a special love for bank debt closed end funds.

I get the idea — short rates are going to rise because the Fed is tightening and inflation is rising globally, and there is no credit risk anymore because economic growth is accelerating globally — it’s not just a US/Trump thing.  I just have a harder time playing the game because we are in the wrong phase of the credit cycle — profit growth is nonexistent, and debts are growing.

I have a few other concerns as well.  Even if encouraging exports and discouraging imports aids the US economy for a while (though I doubt it — more jobs rely on exports than are lost by imports, what if there is retaliation?) there is a corresponding opposite impact on the capital account — less reinvestment in the US.  We could see higher yields…

That said, I would be more bearish on the US Dollar if it had some real competition.  All of the major currencies have issues.  Gold, anyone?  Low short rates and rising inflation are the ideal for gold.  Watch the real cost of carry go more negative, and you get paid (sort of) for holding gold.

If growth and inflation persist globally (consider some of the work @soberlook has  been doing at The WSJ Daily Shot — a new favorite of mine, even his posts are too big) then almost no bonds except the shortest bonds will be any good in the intermediate-term — back to the ’70s phrase “certificates of confiscation.”  One other effect that could go this way — if the portion of Dodd-Frank affecting bank leverage is repealed, the banks will have a much greater ability to lend overnight, which would be inflationary.  Of course, they could just pay special dividends, but most corporations lean toward growing the business, unless they are disciplined capital allocators.

But it is not assured that the current growth and inflation will persist.  M2 Monetary velocity is still low, and the long end of the yield curve does not have yield enough priced in for additional growth and inflation.  Either long bonds are a raving sell, or the long end is telling us we are facing a colossal fake-out in the midst of too much leverage globally.

Summary

I’m going to stay high quality and short for now, but I will be watching for the current trends to break.  I may leg into some long Treasuries, and maybe some foreign bonds.  Gold looks interesting, but I don’t think I am going there.  I’m not making any big moves in the short run — safe and short feels pretty good for the bond portfolios that I manage.  I think it’s a time to preserve principal — there is more credit risk than the market is pricing in.  It might take a year or two to get there, or it might be next month… I would simply say stay flexible and look for a time where you have better opportunities.  There is no fat pitch at present for long only investors like me.

Postscript

To those playing with fire buying dividend paying common stocks, preferred stocks, MLPs, etc. for yield — if we hit a period where credit risk becomes obvious — all of your “yield plays” will behave like stocks in a poisoned sector.  There could be significant dividend cuts.  Dividends are not guaranteed like bonds — bonds must pay or it is bankruptcy.  Managements avoid defaulting on their bonds and loans, but will not hesitate to cut or not pay dividends in a crisis — it is self-preservation, at least in the short-run.  Even if they get replaced by angry shareholders, the management typically gets some sort of parachute if the company survives, and far less in bankruptcy.

One final note on this point — stocks that have a lot of yield buyers behave more like bonds.  If bond yields rise above current stock earnings yields, the stock prices will fall to reprice the yield of the stock, even if there is no bankruptcy risk.

And, if you say you can hold on and enjoy the rising dividends of your high quality companies?  Accidents happen, the same way they did to some people who bought houses in the middle of the last decade.  Many could not ride out the crisis because of some life event.  Make sure you have a margin of safety.  In a really large crisis, the return on risk assets may look decent from ten years before to ten years after, but a lot of people get surprised by their need to draw on those assets at the wrong moment — bad events come in bunches, when the credit cycle goes bust. Be careful, and don’t reach for yield.

Photo Credit: eflon || Ask to visit the Medieval dining hall!  Really!

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December 2016February 2017Comments
Information received since the Federal Open Market Committee met in November indicates that the labor market has continued to strengthen and that economic activity has been expanding at a moderate pace since mid-year.Information received since the Federal Open Market Committee met in December indicates that the labor market has continued to strengthen and that economic activity has continued to expand at a moderate pace.No real change.
Job gains have been solid in recent months and the unemployment rate has declined.Job gains remained solid and the unemployment rate stayed near its recent low.No real change.
Household spending has been rising moderately but business fixed investment has remained soft.Household spending has continued to rise moderately while business fixed investment has remained soft.No real change.
 Measures of consumer and business sentiment have improved of late.New sentence.
Inflation has increased since earlier this year but is still below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports.Inflation increased in recent quarters but is still below the Committee’s 2 percent longer-run objective.Shades their view of inflation up.
Market-based measures of inflation compensation have moved up considerably but still are low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.Market-based measures of inflation compensation remain low; most survey-based measures of longer-term inflation expectations are little changed, on balance.What would be a high number, pray tell?  TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.15%, up 0.07%  from December.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy. But don’t blame the Fed, blame Congress.
The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will strengthen somewhat further. Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will rise to 2 percent over the medium term.Drops references to falling energy prices stopping, and wage pressures. Strengthens language on inflation, which is a slam dunk, given that it is there already on better inflation measures than the PCE deflator.

CPI is at +2.1% NOW, yoy.

Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.No change.
In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1/2 to 3/4 percent.In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1/2 to 3/4 percent.No change. Builds in the idea that they are reacting at least partially to expected future conditions in inflation and labor.
The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation.The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation.No change. They don’t get that policy direction, not position, is what makes policy accommodative or restrictive.  Think of monetary policy as a drug for which a tolerance gets built up.

What would a non-accommodative monetary policy be, anyway?

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.No change.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.  Gives the FOMC flexibility in decision-making, because they really don’t know what matters, and whether they can truly do anything with monetary policy.
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.No change.
The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.No change.  Says that they will go slowly, and react to new data.  Big surprises, those.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Says it will keep reinvesting maturing proceeds of treasury, agency debt and MBS, which blunts any tightening.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Esther L. George; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; Jerome H. Powell; and Daniel K. Tarullo.Full agreement; new people.

 

Comments

  • The FOMC holds, but deludes itself that it is still accommodative.
  • The economy is growing well now, and in general, those who want to work can find work.
  • Maybe policy should be tighter. The key question to me is whether lower leverage at the banks was a reason for ultra-loose policy.
  • The change of the FOMC’s view is that inflation is higher. Equities are stable and bonds fall a little. Commodity prices rise and the dollar weakens.
  • The FOMC says that any future change to policy is contingent on almost everything.

The global economy is growing, inflation is rising globally, the dollar is rising, and the 30-year Treasury has not moved all that much relative to all of that.  My guess is that the FOMC could get the Fed funds rate up to 2% if they want to invert the yield curve.  A rising dollar will slow the economy and inflation somewhat.

Aside from that, I am looking for what might blow up.  Maybe some country borrowing too much in dollars?  Tightening cycles almost always end with a bang.

Data from the CIA Factbook

Data from the CIA Factbook

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I write about this every now and then, because human fertility is falling faster then most demographers expect. Using the CIA Factbook for data, the present total fertility rate for the world is 2.407 births per woman that survives childbearing. That is down from 2.425 in 2014, 2.467 in 2012, and 2.489 in 2010.  At this rate, the world will be at replacement rate (2.1), somewhere between 2035 and 2040. That’s a lot earlier than most expect, and it makes me suggest that global population will top out somewhat below 9 Billion in 2050, lower and earlier than most expect.

Have a look at the Total Fertility Rate by group in the graph above. The largest nations for each cell are listed below the graph. Note Asian nations to the left, and African nations to the right.

Africa is so small, that the high birth rates have little global impact. Also, AIDS consumes their population, as do wars, malnutrition, etc.

The Arab world is also slowing in population growth. When Saudi Arabia at replacement rate (2.11), you can tell that the women are gaining the upper hand there, which is notable given the polygamy is permitted.

In the Developed world, who leads in fertility? Israel at 2.66. Next is France at 2.07 (Arabs), New Zealand at 2.03, Iceland at 2.01, Ireland at 1.98 (up considerably), UK at 1.89, Sweden at 1.88, and the US at 1.87, which is below replacement. The US still grows from immigration, as does France.

Most of the above is a quick update of my prior pieces, which have some additional crunchy insights.  When I look at the new data, I wonder if developed nations might not finally be waking up to the birth dearth.  Take a look at this graph:

Now, the bottom left is a little crammed.  What if I expand it?

I did the second graph in order to make the point that nations with fertility below 1.76 in 2010 tended to increase their fertility, while those above 1.76 tended to decrease it.  Not that you should trust any statistical analysis, but if you could, this is statistically significant at a level well above 99%.  (Note: this is an ordinary least squares regression.  Every “nation” is weighted equally.  If I get asked nicely, I could do a weighted least squares regression which gives heavy weight to China, India and the US, and less weight to Somalia, the West Bank, and Tonga.  I don’t think the result would change much.)

I’m chuckling a little bit as I write this, because this is an interesting result, and one that I never thought I would be writing when I started this project.  Interesting, huh?  My guess is that there is a limit to how much you can get people to reduce family sizes before they begin to question the idea.  Older parents may say, “What was that all about?” but children are usually fun and cute when they are little if they are reasonably disciplined.

One final note: I’ve been running into a lot of demographic articles of late, but this was the one that got me to write this: The World’s Most Populous Country Is Turning Gray.  The barbaric “One Child Policy” of China is having its impact; demography is often destiny.  That said, over the last six years China’s total fertility rate has moved from 1.54 to 1.60.

As it says in the article:

Births in 2016 reached 17.86 million, the most since 2000, rising by 1.91 million from 2015, the National Health and Family Planning Commission said this month. That still falls short of the official projection. Last June, the ministry estimated there would be an increase of 4 million new births every year until 2020. China will continue to implement the two-child policy to promote a balanced population, the plan said.

Fertility doesn’t turn on a dime.  When women conclude that the rewards of society (money, power, approval of peers) go to those with fewer children, that’s a tough cultural idea to overcome.  I would conclude that it will take a lot longer than a single five-year plan to turn around birthrates in China… if they can be turned around at all.  All across Asia, marriages happen at lesser rates, happen later, and produce fewer children.  China is one of the more notable examples.

PS — Picky note: the two-child policy in China is only available to a husband and wife where at least one is an “only child.”  It won’t create a balanced population near replacement rate, as everyone else must have only one child (with exceptions).

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November 2016December 2016Comments
Information received since the Federal Open Market Committee met in September indicates that the labor market has continued to strengthen and growth of economic activity has picked up from the modest pace seen in the first half of this year.Information received since the Federal Open Market Committee met in November indicates that the labor market has continued to strengthen and that economic activity has been expanding at a moderate pace since mid-year.FOMC shades GDP up.
Although the unemployment rate is little changed in recent months, job gains have been solid.Job gains have been solid in recent months and the unemployment rate has declined.Shades up their view on labor.
Household spending has been rising moderately but business fixed investment has remained soft.Household spending has been rising moderately but business fixed investment has remained soft.No change.
Inflation has increased somewhat since earlier this year but is still below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports.Inflation has increased since earlier this year but is still below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports.Shades their view of inflation up.
Market-based measures of inflation compensation have moved up but remain low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.Market-based measures of inflation compensation have moved up considerably but still are low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.No change.  TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.08%, up 0.24%  from November.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will strengthen somewhat further.The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will strengthen somewhat further.No change.
Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.No change. CPI is at +1.6% now, yoy.
Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.No change.
Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent.In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1/2 to 3/4 percent.Builds in the idea that they are reacting at least partially to expected future conditions in inflation and labor.
The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives. Sentence dropped.
The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation.Shades down their view of how accommodative monetary policy is.

They don’t get that policy direction, not position, is what makes policy accommodative or restrictive.  Think of monetary policy as a drug for which a tolerance gets built up.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.No change.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.  Gives the FOMC flexibility in decision-making, because they really don’t know what matters, and whether they can truly do anything with monetary policy.
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.No change.
The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.No change.  Says that they will go slowly, and react to new data.  Big surprises, those.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Says it will keep reinvesting maturing proceeds of agency debt and MBS, which blunts any tightening.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Esther L. George; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.Full agreement
Voting against the action were: Esther L. George and Loretta J. Mester, each of whom preferred at this meeting to raise the target range for the federal funds rate to 1/2 to 3/4 percent.Prior dissenters are now happy, but was a 0.25% increase enough?  Or, as Steve Hanke has said, has monetary policy had to be loose to fight lower bank leverage?

Comments

  • The FOMC tightens 1/4%, but deludes itself that it is still accommodative.
  • The economy is growing well now, and in general, those who want to work can find work.
  • Maybe policy should be tighter. The key question to me is whether lower leverage at the banks was a reason for ultra-loose policy.
  • The change of the FOMC’s view is that inflation is higher. Equities and bonds fall. Commodity prices fall and the dollar strengthens.
  • The FOMC says that any future change to policy is contingent on almost everything.

Photo Credit: elycefeliz

Photo Credit: elycefeliz || Duck, it’s a financial crisis! 😉

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Should a credit analyst care about financial leverage?  Of course, the amount and types of financial claims against a firm are material to the ability of a firm to avoid defaulting on its debts.  What about operating leverage?  Should the credit analyst care?  Of course, if a firm has high fixed costs and low variable costs (high operating leverage), its financial position is less stable than that of a company that has low fixed costs and high variable costs.  Changes in demand don’t affect a firm as much if they have low operating leverage.

That might be fine for industrials and utilities, but what about financials?  Aren’t financials different?  Yes, financials are different as far as operating leverage goes because for financial companies, operating leverage is the degree of credit risk that financials take on in their assets. Different types of lending have different propensities for loss, both in terms of likelihood and severity, which are usually correlated.

A simple example would be two groups of corporate bonds —  one can argue over new classes of bond ratings, but on average, lower rated corporate bonds default more frequently than higher rated bonds, and when they default, the losses are typically greater on the lower rated bonds.

As such the amount of operating risk, that is, unlevered credit risk, is material to the riskiness of financial companies.

Credit analysis gets done on financial companies by many parties: the rating agencies, private credit analysts, and implicitly by financial regulators.  They all do the same sorts of analyses using similar underlying theory, though the details vary.

Regulators typically codify their analyses through what they call risk-based capital.  Given all of the risks a financial institution takes — credit, asset-liability mismatch, and other liability risks, how much capital does a financial institution need in order to stay solvent?  Along with this usually also comes cash flow testing to make sure that the financial companies can withstand runs on their capital structure.

When done in a rigorous way, this lowers the probability and severity of financial failures, including the remote possibility that taxpayers could be tagged in a crisis to cover losses.  In the life insurance industry, actuaries have worked together with regulators to put together a fair system that is hard to game, and as such, few life and P&C insurance companies went under during the financial crisis.  (Note: AIG went under due to its derivative subsidiary and that they messed with securities lending agreements.  The only failures in life and P&C insurance were small.)

Banks have risk-based capital standards, but they are less well-designed than those of the US insurance industry, and for the big banks they are more flexible than those for insurers.  If I were regulating banks, I would get a small army of actuaries to study bank solvency, and craft regulations together with a single banking regulator that covers all depositary financials (or, state regulators like in insurance which would be better) using methods similar to those for the insurance industry.  Then every five years or so, adjust the regulations because as they get used, problems appear.  After a while, the methods would work well.  Oh, I left one thing out — all banks would have a valuation actuary reporting to the board and the regulators who would do the cash flow testing and the risk-based capital calculations.  Their positions would be funded with a very small portion of money that currently goes to the FDIC.

This would be a very good system for avoiding excessive financial risk.  Dreaming aside, I write this this evening because there are other dreamers proposing a radically simple system for regulating banks which would allow them to write business with no constraint at all with respect to credit risk.  All banks would face a simple 10% leverage ratio regardless of how risky their loan books are.  This would in the short run constrain the big banks because they would need to raise capital levels, though after that happened, they would probably write riskier loans to get their return on equity back to where it was.

My main point here is that you don’t want to incent banks to write a lot of risky loans.  It would be better for banks to put aside the right amount of capital versus varying classes of risk, and size the amount of capital such that it is not prohibitive to the banking system.

As such, a simple leverage ratio will not cut it.  Thinking people and their politicians should reject the current proposal being put out by the Republicans and instead embrace a more successful regulatory system manned by intelligent and reasonably risk-averse actuaries.

Photo Credit: Jessica Lucia

Photo Credit: Jessica Lucia || That kid was like me… always carrying and reading a lot of books.

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If you knew me when I was young, you might not have liked me much.  I was the know-it-all who talked a lot in the classroom, but was quieter outside of it.  I loved learning.  I mostly liked my teachers.  I liked and I didn’t like my fellow students.  If the option of being home schooled had been offered to me, I would have jumped at it in an instant, because then I could learn with no one slowing me down, and no kids picking on me.

I read a lot. A LOT.  Even when young I spent my time on the adult side of the library.  The librarians typically liked me, and helped me find stuff.

I became curious about investing for two reasons. 1) my mother did it, and it was difficult not to bump into it.  She would watch Wall Street Week, and often, I would watch it with her.  2) Relatives gave me gifts of stock, and my Mom taught me where to look up the price in the newspaper.

Now, if you knew the stocks that they gave me, you would wonder at how I still retained interest.  The two were the conglomerate Litton Industries, and the home electronics company Magnavox.  Magnavox was bought out by Philips in 1974 for a price that was 25% of the original cost basis of my shares.  We did worse on Litton.  Bought in the mid-to-late ’60s and sold in the mid-’70s for a 80%+ loss.  Don’t blame my mother for any of this, though.  She rarely bought highfliers, and told me that she would have picked different stocks.  Gifts are gifts, and I didn’t need the money as a kid, so it didn’t bother me much.

At the library, sometimes I would look through some of the research volumes that were there for stocks.  There are a few things that stuck with me from that era.

1) All bonds traded at discounts.  It’s not that I understood it well, but I remember looking at bond guides, and noted that none of the bonds traded over $100 — and not surprisingly, they all had low coupons.

In those days, some people owned individual bonds for income.  I remember my Grandma on my mother’s side talking about how little one of her bonds paid in interest, given that inflation was perking up in the 1970s.  Though I didn’t hear it in that era, bonds were sometimes called “certificates of confiscation” by professionals  in the mid-to-late ’70s.  My Grandpa on my father’s side thought he was clever investing in short-term CDs, but he never changed on that, and forever missed the rally in stocks and long bonds that kicked off in 1982.

When I became a professional bond investor at the ripe old age of 38 in 1998, it was the opposite — almost all bonds traded at premiums, and had relatively high coupons.  Now, at that time I knew a few firms that were choking because they had a rule that said you can never buy premium bonds, because in a bankruptcy, the premium will be automatically lost.  Any recoveries will be off the par value of the bond, which is usually $100.

2) Many stocks paid dividends that were higher than their earnings.  I first noticed that while reading through Value Line, and wondered how that could be maintained.  The phrase “borrowing the dividend” was bandied about.

Today as a professional I know that we should look at free cash flow as a limit for dividends (and today, buybacks, which were unusual to unheard of when I was a boy), but earnings still aren’t a bad initial proxy for dividend viability.  Even if you don’t have a cash flow statement nearby, if debt is expanding and earnings don’t cover the dividend, I would be concerned enough to analyze the situation.

3) A lot of people were down on stocks and bonds — there was a kind of malaise, and it did not just emanate from Jimmy Carter’s mind. [Cue the sad Country Music] Some concluded that inflation hedges like homes, short CDs, and gold/silver were the only way to go.  I remember meeting some goldbugs in 1982 just as the market was starting to take off, and they disdained the idea of stocks, saying that history was their proof.

The “Death of Equities” came and went, but that reminds me of one more thing:

4) There was a decent amount of pessimism about defined benefit plan pension funding levels and life insurer solvency.  Inflation and high interest rates made life insurers look shaky if you marked the assets alone to market (the idea of marking liabilities to market was at least 10 years off in concept, and still hasn’t really arrived, though cash flow testing accomplishes most of the same things).  Low stock and bond prices made pension plans look shaky.  A few insurance companies experimented with buying gold and other commodities, just in time for the grand shift that started in 1982.

Takeaways

The biggest takeaway is to remember that as a fish you don’t notice the water that you swim in.  We are so absorbed in the zeitgeist (Spirit of the Times) that we usually miss that other eras are different.  We miss the possibility of turning points.  We miss the possibility of things that we would have not thought possible, like negative interest rates.

In the mid-2000s, few thought about the possibility of debt deflation having a serious impact on the US economy.  Many still feared the return of inflation, though the peacetime inflation of the late ’60s through mid-’80s was historically unusual.

The Soviet Union will bury us.

Japan will bury us.  (I’m listening to some Japanese rock as I write this.) 😉

China will bury us.

Few people can see past the zeitgeist.  Many can’t remember the past.

Should we be concerned about companies not being able pay their dividends and fulfill their buybacks?  Yes, it’s worth analyzing.

Should we be concerned about defined benefit plan funding levels? Yes, even if interest rates rise, and percentage deficits narrow.  Stocks will likely fall with bonds if real interest rates rise.  And, interest rates may not rise much soon.  Are you ready for both possibilities?

Average people don’t seem that excited about any asset class today.  The stock market is at new highs, and there isn’t really a mania feel now.  That said, the ’60s had their highfliers, and the P/Es eventually collapsed amid inflation and higher real interest rates.  Those that held onto the Nifty Fifty may not have lost money, but few had the courage.  Will there be a correction for the highfliers of this era, or, is it different this time?

It’s never different.

It’s always different.

Separating the transitory from the permanent is tough.  I would be lying to you if I said I could do it consistently or easily, but I spend time thinking about it.  As Buffett has said, (something like) “We’re paid to think about things that can’t happen.

Ending Thoughts

Now, lest the above seem airy-fairy, here are my biases at present as I try to separate the transitory from the permanent:

  • The US is in better shape than most of the rest of the world, but its securities are relatively priced for that reality.
  • Before the US has problems, Japan, China, OPEC, and the EU will have problems, in about that order.  Sovereign default used to be a large problem.  It is a problem that is returning.  As I have said before — this era reminds me of the 1840s — huge debts and deficits, with continued currency debasement.  Hopefully we don’t get a lot of wars as they did in that decade.
  • I am treating long duration bonds as a place to speculate — I’m dubious as to how much Trump can truly change things.  I’m flat there now.  I think you almost have to be a trend follower there.
  • The yield curve will probably flatten quickly if the Fed tightens more than once more.
  • The internet and global demographics are both forces for deflationary pressure.  That said, virtually the whole world has overpromised to their older populations.  How that gets solved without inflation or defaults is a tough problem.
  • Stocks are somewhat overvalued, but the attitude isn’t frothy.
  • DIvidend stocks are kind of a cult right now, and will suffer some significant setback, particularly if interest rates rise.
  • Eventually emerging markets and their stocks will dominate over developed markets.
  • Value investing will do relatively better than growth investing for a while.

That’s all for now.  You may conclude very differently than I have, but I would encourage you to try to think about the hard problems of our world today in a systematic way.  The past teaches us some things, but not enough, which should tell all of us to do risk control first, because you don’t know the future, and neither do I. 🙂

 

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Well, I’m back in suburban Baltimore after the struggle of getting to the the center of DC and back.  It takes a lot of energy to write 4000 or so words, tweet 26 times, meet new people, old friends, etc.  Here are some thoughts after the sip from the firehose:

1) There was almost no media there this time.  Maybe it’s all the action associated with a new president being elected.  All the same, I see almost nothing on the web right now aside from the Twitter hashtag #CatoMC16 and my posts echoed at ValueWalk.

2) I came out of the conference thinking that I need to read three of the papers, the ones by:

  • Hanke & Sekerke — color me dull, but it finally dawned on me the potential degree to which structural regulatory change has been fighting ZIRP.
  • Jordan — his idea on how to sop up excess liquidity sounds interesting.
  • Goodspeed — I am a sucker for economic history — it broadens the categories that you think in.  His presentation was very data-oriented, and I thought the methodology was clever for analyzing alternative deposit guarantee methods back in a time when the states regulated the banks.  (Please bring back state regulation of banks; it works better.  Many more failures, but they are all small.)

3) Jim Grant is always educational to listen to.  I also appreciated O’Driscoll, Thornton, Orphanides, and Hoenig.

4) I would not invite back Spitznagel (irrelevant), Allison, Todd, and Gramm (three living in fantasyland).

5) That brings me to the fantasies of the conference as I see them.  This is what I think is true:

  • The Community Reinvestment Act [CRA] was not a big factor in the crisis, aside from the GSEs.  Intelligent banks make decent CRA loans; I’ve seen it done.
  • Subprime lending was the leading edge of of bad lending on residential real estate, but regulators did not do their jobs well in supervising lending.
  • Tangible bank leverage was way too high, and was a large part of the crisis.  So was a lack of liquidity from losing the wholesale funding markets, which disproportionately hit the big banks.
  • The big banks were disproportionately insolvent, though a few of them did not need more capital, like US Bancorp BB&T, and Wells Fargo.  Many more small banks were insolvent also, but they weren’t big enough to move the systemic risk needle.
  • Banks are a little over-regulated, but given the poor ways that they managed liquidity prior to the crisis, you can’t blame Dodd-Frank for trying to avoid that problem again.
  • The big bank stress tests are not real in the US or Europe; they exist to mollify politicians and bamboozle the public.  If they ARE real, then publish the data, methods and results in detail.
  • Banks need a strong risk based capital formula.  The one for insurers works very well.  Perhaps banks should imitate the stronger and smarter solvency regulations that insurers use.  They might even find them looser than what they currently do, but be more accurate as to real risks.
  • Inverting the yield curve is necessary in a fiat money system.  You need to deflate and liquidate bad lending so that new lending in the next part of the credit cycle can recycle the capital to better projects.

6) That brings me to the realities of the conference as I see them.  This is what I think is true:

  • Fannie/Freddie were a large part of the crisis.  Undercapitalized relative to the amount of default risk they were taking.
  • Housing prices were pushed too high as a result of too much debt getting applied to finance them.  Loose monetary policy aided the creation of this debt.  Falling housing prices were the main cause of the crisis, as many loans became inverted, and a slowing economy led to many losing their ability to pay their mortgages.
  • We needed a different bailout where bank stockholders lost all, and debtholders lose also, only after that should the FDIC have been tapped to protect depositors.
  • Bank solvency is important for the long run for the economy.  A crisis like the last one erases a lot of the growth that would occur from looser bank regulatory policy.  Things may be tight now, but once the system adjusts, growth should resume.
  • A healthier economy has lower debt and less debt leverage/complexity.  Debt and layered debts make an economy inherently fragile.
  • A gold standard does not increase instability, unless banks are mis-regulated for solvency.
  • The wealth effect is tiny, and the Fed should stop pretending that it does much.

7) While at Cato, I noticed the area named for Rose Wilder Lane, the same Rose in the “Little House on the Prairie” books (daughter of Laura and Almonzo Wilder).  She was a libertarian later in life, and knew Ayn Rand.  Their pictures are near each other in Cato’s basement.  Just a little trivia.

8 ) There was a lot of sympathy for the idea of not paying interest on excess reserves, and certainly not same rate as on required reserves.

That’s all.